What is the impact of falling rupee on Indian markets?

In the last few months the rupee has plummeted sharply from 64/$ to a low of 74/$ in the midst of concerns over global and domestic macros. On the global front there was the consistent rise in oil prices, a stronger dollar and an ensuing trading war. In addition, the Middle East was again in the midst of a geopolitical crisis after the Khashoggi killing and Italy was threatening to tear the Euro apart. On the domestic front, the IL&FS fiasco spooked the Indian markets. In addition, the sharply higher landed price of oil, rising inflation and rising trade deficit also played spoilsport. On top of that, the CAD threatened to cross the 3% limit which also proved to be a bugbear for the rupee. The bigger question is does the rupee weakness negatively impact the stock markets and why so?

The landed cost of crude goes up and so do oil prices

This is a problem largely because India relies on imports to meet 75% of its oil needs on a daily basis. Bank of America is already talking about $100/bbl and that is a distinct possibility if the US China trade war fizzles and global oil demand is back. Even the world’s largest exporter of oil, Saudi Arabia, has been hinting at a level of $100/bbl for Brent crude. As oil becomes more expensive, it fuels inflation locally and makes a case for higher interest rates. At the same time, higher crude prices also puts pressure on the trade deficit which is already hovering around $18 billion per month till the August (but had cooled down to $13.98 billion in September). The CAD at close to 3% could put further pressure on the rupee and also on the external rating of the rupee.

Don’t be surprised to see risk-off flows out of India

Did you know that FIIs have sold nearly Rs.1 trillion worth of debt and equities in the last 10 months of the current fiscal? In the month of October alone, FIIs sold nearly Rs.39,000 crore of which over 70% was in equities and only the balance in debt. Foreign portfolio flows into debt is most vulnerable to weakness in the rupee and can lead to risk off trades on spreads turning unfavourable. In India foreign flows into debt are driven by the yield spread (between the US and India) and the strength of the INR. If the rupee is weakening then global investors will look to pull money out of India and park it in safe havens. This at times becomes a catch-22 situation with weak rupee leading to capital outflows and these outflows in turn leading to further weakening of the rupee. Remember, India still relies on such hot money flows to bridge her fiscal deficit gap.

It impacts the cost structure of Indian companies

This is partly the oil story because higher oil prices leading to an across-the-board rise in costs for Indian companies. But there are other industries like capital goods, telecom, power and chemicals which depend on import of key inputs from abroad. Since most of these imports are denominated in US dollars, a weak rupee could put pressure on the cost structure of Indian companies. A pressure on costs will mean pressure on OPMs (Operating Profit Margins) and NPMs (Net Profit Margins).

Foreign currency brokers like ECB and FCCB have a problem on hand

Let us understand this currency risk with a real example. Assume that Greta Ltd. had borrowed a 1 year loan of $5 million through Foreign Currency Bonds at 5% interest. Let us also assume that when this loan was taken on Jan 01st the INR was at 63.30/$ and when the loan is repaid after 1 year, the INR is at 69.20/$. Check the table below:

Particulars (Borrow)

Amount

Particulars (Repay)

Amount

Amount Borrowed

$5 million

Amount Repaid

$5 million

Exchange Rate

63.30/$

Exchange Rate

69.20/$

Rupee amount Raised

Rs.31.65 crore

Rupee Amount Repaid

Rs.34.60 crore

Interest cost

5%

Interest paid

Rs.1.583 crore

Original Interest Cost

Rs.1.583 crore

Currency Costs

Rs.2.950 crore

Actual Cost of Loan

Rs.4.533 crore

Actual Rupee Interest

14.32%

You can see how a weak rupee can add to cost of borrowings in case of foreign borrowings. Normally, when companies borrow in dollars, they hedge with a forward cover. Had the company not taken the forex cover, then the actual rupee interest cost would have been 14.32% instead of 5% after considering the currency effect.

The moral of the story is that the currency value has a deep impact on markets. Economists argue that weak rupee encourages exports and solves a lot of problems. But that argument has hardly worked for India. That is because, India has always been a net importer, especially with respect to capital goods and oil.